IRA Missteps

Last month we put out an article about Inherited IRAs.  We received so many questions and comments that we thought a kind of part two would be appropriate.  Not surprisingly, none of our clients want to hand their heirs a big tax problem…we asked.   Why would they want to hand the IRS a sizable chunk of their wealth? If you misunderstand the rules when it comes to inherited IRAs, you just might. Here are some missteps that IRA owners and IRA heirs often make – financial choices to regret.

Thinking that a will or a trust can facilitate the transfer of IRA assets. IRAs don’t pass to heirs through wills or trusts (a few rare exceptions aside). The beneficiary form takes precedence – the form the IRA owner filled out and signed when opening the account. Problems arise when

• The IRA owner dies without designating a beneficiary
• The designated beneficiary has also passed away
• No one can find the beneficiary form (not even the IRA custodian, i.e., the financial institution that hosts the IRA)

In these circumstances, IRA heirs commonly end up playing by the IRA custodian’s rules. The resulting beneficiary may be the IRA owner’s estate – a very undesirable tax consequence. It might be a contingent beneficiary – perhaps a very undesirable emotional consequence. The lesson here is to keep the beneficiary form handy and to let your heirs know where it is.¹

Taking lump-sum distributions. Too often, non-spousal IRA heirs see the inherited assets as money to spend. They withdraw the entire IRA balance in one fell swoop. Bad idea: all that money will be subject to federal income tax. Due to this move, they may lose a third of the IRA assets (or more).²

The alternatives? Non-spousal beneficiaries can open an inherited Roth or traditional IRA to house the inherited assets and simply take Required Minimum Distributions (RMDs) from that inherited IRA under the appropriate schedule.

• Traditional IRA: The age of the original accountholder is the big factor. If the original IRA owner was under age 70½ (i.e., hadn’t taken any RMDs), then distributions must occur within five years of that original IRA owner’s death. Under this “five-year rule”, the entire account balance must be distributed to the beneficiary within those five years. If the account holder was over age 70½ and had already taken RMDs, then the inherited IRA assets may be distributed gradually over the projected lifespan of the beneficiary according to IRS tables. Yearly distributions from an inherited IRA must start by December 31 of the year after the year in which the original IRA owner died. (If you’re going by the “five-year rule”, the distributions aren’t required to begin in the year following the original IRA owner’s passing.)³
• Roth IRA: Instead of a hard choice, a non-spousal beneficiary of an inherited Roth IRA can select from one of two options. He or she can withdraw 100% of the inherited Roth IRA balance within five years of the original Roth IRA owner’s death, or over your remaining life expectancy as calculated through IRS tables. Withdrawals from an inherited Roth IRA are usually tax-exempt if the original IRA owner’s first contribution to the account was made more than five years ago.³

If you don’t have to go by the “five-year rule”, the invested IRA assets may keep compounding across many years with the added benefit of tax deferral.

You can also “disclaim” some or all of any inherited IRA assets, which could be a wise move for tax purposes if you don’t need the inherited funds.³

Not realizing your four options when you inherit your spouse’s IRA. If a spouse dies, the surviving spouse that inherits an IRA has some choices. He or she can

• Roll over the assets into a beneficiary IRA
• Convert the inherited IRA into your own IRA
• Take a lump sum distribution
• “Disclaim” up to 100% of the deceased spouse’s IRA assets

There are compelling reasons to go with the rollover. The widowed spouse can set up an RMD schedule based on his or her life expectancy. This second point is really important, because the rollover allows the surviving spouse to put off the RMDs that would otherwise soon need to happen. In fact, the surviving spouse can wait until the year in which the original IRA owner would have turned 70½ to start taking required withdrawals from the IRA.²

If you inherit a Roth IRA from your spouse, you may be able to roll the assets into a Roth IRA of your own or treat the Roth IRA you received from your spouse as your own if you are the sole beneficiary. This is worth noting, as Roth IRA owners will never have to make mandatory annual withdrawals from their IRAs.³

Incidentally, there is no such thing as an early withdrawal penalty from an inherited IRA. Inherited IRA withdrawals are never hit with the 10% early distribution penalty as the funds are categorized as death proceeds. To certify this, the IRA custodian or trustee needs to report these withdrawals as “death distributions” in Box 7 of Form 1099-R.⁴

If the spouse converts the IRA into his or her own IRA, the surviving spouse can name a beneficiary for the inherited assets, keep contributing to the IRA, and potentially avoid RMDs until he or she turns 70½.⁵

Alternately, a surviving spouse who doesn’t really need inherited IRA assets can “disclaim” them, meaning that they will go to a contingent beneficiary. Sometimes this can be a wise move for tax purposes.⁶

Non-spousal heirs fail to retitle an inherited IRA. If this isn’t done in the year following the year in which the original IRA owner passed, then there can be no direct rollover of the inherited IRA assets and no “stretch” for those assets.^2,7

What happens if a non-spouse beneficiary just rolls the inherited IRA assets into an IRA they own, one that isn’t retitled? Then it is not a direct rollover. The IRS treats those inherited IRA assets like a fully taxable cash distribution – 100% of it is subject to income tax.⁷

Ask for help, and don’t be afraid to ask questions. Many families and couples have only a hazy understanding of the rules governing IRAs, and few really know all the options. Make sure your IRA beneficiary form is up to date, and speak with an advisor at Merit Wealth Management, LLC about how to handle the transfer of IRA assets when the time comes. 

1 - investopedia.com/articles/pf/07/beneficiary_form.asp [3/23/11]

2 - schwab.com/cms/P-1625576.3/CS13416-02_MKT13598-10_FINAL_118091.pdf?cmsid=P-1625576&cv7 [6/24/11]

2 - schwab.com/cms/P-1625576.3/CS13416-02_MKT13598-10_FINAL_118091.pdf?cmsid=P-1625576&cv7 [6/24/11]

2 - schwab.com/cms/P-1625576.3/CS13416-02_MKT13598-10_FINAL_118091.pdf?cmsid=P-1625576&cv7 [6/24/11]

3 - axa-equitable.com/retirement/inheriting-an-ira-or-employer-sponsored-plan.html [6/09]

4 - marketwatch.com/story/the-10-vital-rules-for-inherited-iras-2009-11-12 [11/12/09]

5 - jhrollover.com/article_beneficiary_basics_final.shtml [3/23/11]

6 - investopedia.com/articles/retirement/03/041603.asp [4/16/03]

7 - online.wsj.com/article/SB125512471450876777.html [10/10/09]

This material is derived from sources believed to be reliable, but its accuracy and the opinions based thereon are not guaranteed. The content of this publication is for general information only and is not intended to serve as specific financial, accounting or tax advice. Copyright © 2011, Merit Wealth Management, LLC